The Coming China Dollar Problem

2019-08-09 | Sam Shames

The U.S. Dollar has been very much in focus over the past couple of months.

Traders believe that the Fed’s easing policies may have a negative effect on the Dollar moving forward. It won’t, and here is why.

All currencies are traded as relative value, meaning that in order for the Dollar to fall another major currency would need to appreciate in value.

Let’s look at the potential currencies that could fill this role. First the Euro… the Euro is a cobbled together currency, largely held together by German GDP. Germany has been showing signs of distress and their once powerhouse economy is contracting. Also, Europe is running negative rates so another factor that will prevent the Euro from outpacing the dollar.

Next, we have the British Pound and the Japanese Yen. The Pound is a non-starter in terms of appreciation in value because of its relationship with the Euro and the uncertainty around Brexit.

The Japanese Yen, I do believe will appreciate in value considerably, however it will likely only keep up with the Dollar strength or, at best, perform slightly stronger.

So, that leaves us with one more currency and the topic of this blog… the Chinese Yuan.

This is where it gets interesting. China’s rise to global superpower over the past 30 years has been impressive. However, much of that growth is because of the inflows of foreign investment capital which has largely buoyed their markets.

This week we saw China allow the Yuan to depreciate against the Dollar breaking the psychological and technical barrier of 7 Yuan to the Dollar.

Why is this important? Because China has explicitly stated they will no longer defend the 7 level. What they were doing before was that every time the Yuan would get to 7 Chinese authorities would step in and buy Yuan while selling dollars.

The question I pose is now that China will not defend the Yuan, how far can this go? I ran some targets on the Yuan chart, which is breaking out, and got a target of 7.50 initially. In the long run, I expect this number to go much higher.

Why is all this important? Because China has a dollar shortage. Much of their debt is dollar-denominated and is not an issue as long as foreign investment flows are strong. The moment that slows because of the perception of a cooling economy, the dollars China does have in reserve become their live blood. They cannot fund themselves without a continuous inflow of dollars.

So, China has two choices both of which are bad.

Option 1 – Defend the Yuan from devaluing by burning their dollars in the forex market to buy it up. This is like selling a vital organ to pay for a home remodel, they will likely not do this.

Option 2 – Allow the Yuan to move by market forces which will begin the devaluation in earnest. In this scenario world markets would move sharply lower, at least initially. This option would allow China to preserve its precious dollar reserves but will increase the cost to import all commodities, of which they are a ravenous consumer of.

Neither option is good, but Yuan devaluation is the more palatable choice for the centrally managed economy.

China is in the middle of multiple battles, from economic to political in Hong Kong. Hong Kong is a blog post unto itself, but it is crucial in the inflow of foreign capital to the Chinese markets. China will do whatever is necessary to break the back of the protests to preserve its control in the region.

All these factors are enormous pressures on a country that is completely dependent on growth. The moment that growth slows, the bills become a reality, and they are all dollar denominated. I expect to see a mad dash for dollars around the world, primarily from Asia.

So, what’s the trade?

Gold, silver, Bitcoin, Dollars, and Yen.

Remember when it comes to stocks… hope takes them up, credit brings them down.

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